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Ken Lam
CEO, Lam Associates Inc.

Let me begin with the perennial question: How does one make $1 million investing in oil & gas stocks? As the joke goes: you start with $2 million and lose half. On the other hand, the smart and lucky investor starts with $10,000, and then finds two consecutive stocks that go up 10 times. Since everyone wants to avoid the former approach and succeed in the latter, it pays to grasp some fundamental concepts.

How to Think About O&G Stocks

Although technically and operationally complex, oil & gas companies are "price-takers". Unlike the majority of businesses, which need to  grow profits through the combination of cost management and sales & marketing, oil & gas companies only have to focus on the former. After all, the revenue of these companies is determined by the market price of energy commodities.

It is useful to think of oil & gas companies as manufacturers possessing high "operational leverage". This refers to companies with high fixed costs and low variable costs where changes in revenue significantly impact profitability. Consider an example. In times of rising energy prices, a producing company’s profitability and share price can rise at a faster rate than the underlying commodity prices themselves because the variable costs to produce the next barrel of oil or cubic foot of gas is very low relative to the company’s fixed costs (e.g. drilling and bringing the well into production). The reverse happens in times of declining oil and gas prices.

This notion is illustrated in the two figures below which plot the S&P/TSX Capped Energy Index versus the WTI spot oil price and the Henry Hub gas spot price, respectively. (The S&P/TSX Capped Energy Index is based on the share prices of 60 Canadian oil & gas companies.) From these figures one can tell that predicting the long term direction of oil & gas prices will probably make you richer than trying to pick the "best" stock. (Sources:  US Energy Administration Information Administration, Toronto Stock Exchange)

One important rule of thumb is that costs per unit of production ($/BOE or "barrel of oil equivalent") should decrease for a well-managed oil & gas company as its production volume increases. Since every oil & gas company receives the same price for its production, the lowest cost producer, i.e. whoever is most successful in replenishing reserves at less than their cost of capital, will be rewarded by the market. Economic value is created only if new production is accretive (i.e. exceeds cost of capital).

Engineer Once, Then Repeat!

In order to achieve — and profit — from greater degrees of efficiency in the manufacturing-like process of oil & gas production, it is key to implement standardization in all processes, from engineering to drilling. In determining whether a company is developing a low cost structure you need to ascertain whether it is using proven techniques and technologies rather than engaging in costly attempts to "re-invent the wheel". Moreover, the corporate culture should be thoroughly instilled with the aim to continually reduce unit costs.

The manufacturing model is more relevant today as oil & gas companies are increasingly focusing on unconventional "resource plays" such as shale gas, tight oil and oil sands. These have a higher fixed cost structure compared to conventional resources and therefore must rapidly achieve maximal scale in production.

On a cautionary note, the prudent investor should bear in mind that commodity stocks are highly cyclical. Do not lend much credence to so-called experts who predict sustained high prices. One favourite theory contends that the emerging multi-billion strong middle-class in the developing world will keep commodity prices high almost indefinitely. Another theory holds that global oil production is peaking and will soon be in irreversible decline. High returns attract new production which invariably leads to over-production and commodity price collapse.

Making money at the beginning of a cycle is easy. As the saying goes: "In a strong wind even turkeys will fly." Great skill — and sometimes great luck — is required to time the cycle right. But bear in mind that even the best managed oil & gas company cannot remain profitable when oil & gas prices fall below its production costs.

The Eternal Exploration & Production Cycle

The life of a junior oil & gas company divides into three stages:

1)    Exploration (acquiring/testing prospective properties through seismic exploratory drilling and delineation); 
2)    Development (well completion and surface infrastructure development); and
3)    Production (production and cash flow).

The change in share price of an oil & gas company as it moves through these different phases is plotted in Figure 3:

Fig 3:  Theoretical plot of oil & gas company's share price from exploration to production stage

The valuation parameters change from stage to stage. During the first two stages, Exploration and Development, the key parameters are 1) Net Asset Value (NAV) per share and 2) Market Capitalization/ BOE reserve (approximately 6,000 cubic feet of natural gas is considered equivalent to one barrel of oil on a BTU basis). During the third stage, Production, the following five valuation parameters are critical:

1. Cash flow per share
2. Earnings per share
3. Market capitalization per BOE reserve
4. Market capitalization per EBITDA
5. NAV per share

The greatest risk/reward opportunity is during the period when a company transitions from development to production. This is a result of the usual lull in the stock’s price once investor euphoria from discovery wanes and uncertainty arises with regard to the timing and cost of the ensuing development. Investor eyes should be poised on the development to production transition as a good entry point. Nevertheless, there are plenty of risks associated with such a move since much can still go awry.

Junior companies are often rich in exploratory opportunities but under-capitalized.  On the other hand, larger oil & gas companies are well-capitalized, have geographical diversification, possess proprietary technologies and can bring large reserves into production at a lower cost. These larger companies can, however, see their share price languish owing to a lack of exploratory opportunities.

As an oil & gas investor, it makes sense to be clear about whether your risk profile inclines you to the junior or senior sector. A junior oil & gas company with 5,000 BOE/day production, for instance, could see its stock price double or triple through a discovery resulting in production of an additional 5,000 BOE/day. By virtue of its already significant size, a senior producer can, on the other hand, rapidly double its production rate under only the rarest of circumstances, such as the acquisition of another senior producer.

Art and Artifice in Evaluating Reserves

Petroleum geology is a highly technical subject whose essence can't be condensed into a short article. The layperson can consider some general pointers when evaluating an oil & gas company’s properties:

• Are they near other properties which contain large, proven reserves?
• Do they possess a large land base for future exploration?
• Are reserves near infrastructure such as roads, pipelines, surface treatment facilities, utilities?

Oil & gas companies will retain independent third party engineering consultants to carry out a Net Asset Value (NAV) evaluation, which is an economic and probabilistic estimate of the value of the company's reserves each year. Such analysts commonly look at the NAV/share price in relation to stock price to conclude that a company is undervalued relative to its market peers.  This methodology is sound in theory, but it has flaws in practice since certain "third party" consultants have the reputation of being unduly generous with their reserve estimates. Since no company wants their stocks to be perceived as over-valued, reserve estimates must be seen with a critical eye. As the American humorist Mark Twain once quipped: "A gold mine is a hole in the ground with a liar standing by it."

Management, Management, Management

Similar to the adage of location, location, location in real estate, you could say it's management, management, management in the oil & gas industry. Barring dumb luck and $200/barrel oil, the management team’s abilities and competence will ultimately determine whether an oil & gas company succeeds or fails. Take my word for it: a management with a past history of success is a good indicator of the team's chance of future successes. So do your homework and assess a management team's track record in transforming resource potential into higher share prices.

You should also consider what type of CEO would serve the firm best depending upon which stage they sit on the production curve. For example, a CEO with a strong geological background may be fitting for a company in the exploration phase but a CEO with a different skills set may be more appropriate as it transitions to production.

Getting into Bed with Insiders

I'm a fan of oil & gas companies whose management has a 10% or higher ownership position. I also keep an eye out for companies with distinguished investment funds and investors committed to large, long-term holdings. After all, the retail investor needs to show respect for the investment decisions of those with superior resources to carry out meticulous due diligence.

The most information about a firm’s prospects is held by "insiders" whose opinions need to be taken most seriously. Fortunately, security regulation requires management and directors to divulge their trading activities and these are tracked by various free (i.e. sedi.ca) and paid sites (i.e. inkresearch.com).

It's said that there can be many reasons why an insider sells his shares (i.e. gambling debts, divorce, illness, etc.), but there is only one reason why an insider buys stock—especially large (non-option) purchases in the open market: because the stock is poised for growth. And can there be any wonder that I get very excited when a CFO buys heavily? After all, accountants are notorious cheapskates inclined to invest only when risk and opportunity move into an ideal relationship.

Cash is King

Oil & gas is a risky, capital intensive business requiring firms to constantly raise cash in order to replenish depleting reserves. An onshore well can cost several million dollars to drill and complete; an offshore well can easily cost more than $100 million.  Consequently, oil & gas companies of all sizes frequently pool their capital and share exploration risks through partnerships, joint ventures or working interest arrangements.

With the exception of the majors, supermajors and state owned firms, few oil & gas companies can finance capital expenditures from cash flow. The pressure to raise capital, through the issuance of equity and debt, never lets up. Actually, many companies do not do it well. This can be attributable to the company's lack of expertise in selling its story. It may also be attributable to the numbers themselves which might suggest the company doesn't have a compelling story.

It is therefore imperative to review each company's financing history to determine if it has been able to consistently raise capital at increasing higher share price as it proceeds up the production curve.  If the company cannot raise funds at higher share prices, it will have to issue more shares and options resulting in dilution for existing shareholders.

When doing your due diligence, it makes sense to evaluate whether the company's directors possess strong capital market backgrounds. Moreover, check to see whether tier 1, tier 2 or tier 3 investment banks have been engaged in raising funds.

Also take a look at the strength of their Balance Sheet. How much debt can they prudently support (i.e. debt -to-cash flow, debt-to-equity)? How much bank credit have they obtained? How much have they used?

A profitable oil & gas company can end up relinquishing one third of its profits to the government in the form of income taxes. As a result, many companies utilize tax losses — acquired from bankrupt companies — to reduce income taxes. The benefits of these tax losses expire at a date that is usually provided in the annual report’s footnotes. Wherever tax losses are used in this manner, one should pay especially attention as their expiry may have an unexpected material impact on the company's financial performance.

Substance versus Bravado

Oil & gas companies which are successful in getting their story out to the market are not only rewarded with a rising share price, they also experience larger trading volumes. With 394 listings on its two major stock exchanges at the end of 2010, Canada has the greatest number of publicly-listed oil & gas companies of any nation. In this super-abundance of competing players, can you identify those features that really differentiate any one company?

All these companies — especially the smaller ones — are vying tooth and nail for investors’ attention and, of course, their investment dollars. The majority of oil & gas companies often have the potential disadvantage of being managed by scientifically-minded engineers and geologists who lack sales acumen. My opening remarks notwithstanding, you need to be convinced that a company takes an aggressive approach to marketing. By the same token, a company that is all bravado and no substance is a recipe for disaster.

With regard to disaster, also be wary of oil & gas companies whose share price increases significantly without a corresponding increase in trading volumes. This may be a sign of market manipulation.

Investor relations materials tell the story as the company would like it told — so read with caution! The same cautious approach is needed when assessing the coverage of analysts. After all, the linkage of an analyst's compensation to the share performance of covered companies can possibly undermine the putative neutrality of his/her judgement.

Closing Thoughts: The Pick of the Pack

The risks facing oil & gas companies are legion: political/geo-political, environmental, regulatory, litigious, force majeure, currency movements, commodity price volatility, etc. Clearly, the junior oil & gas company you have picked from the pack has only a miniscule chance of one day becoming the next ExxonMobil.

If your risk tolerance is modest there are always Exchange Traded Funds (EFTs) which hold oil & gas futures contracts. They are structured so their share price duplicates the market swings of oil & gas prices. There are even ETFs that are "levered" so as to magnify the movement of oil & gas prices by a factor of two or higher.

In contrast to the attempt to pick two stocks set to go up 10 times, investing in an ETF or a similar type of index may be a more realistic strategy. After all, the stock price of even the biggest companies in the world can go to zero (i.e. Enron, Lehman Brothers), but the market price of oil and gas will not.

Ken Lam is CEO of Calgary-based Lam Associates Inc.